The commodity derivatives market is going through a topsy-turvy situation, which is attributed to the intermittent ban or suspension of futures trading for a basket of commodities. While financialisation has impacted the contours of the market, the high regulatory uncertainty and risks have hurt the market sentiment. This would result in a thinly traded market, which leads to poor price discovery and ineffective hedging against price risks.
One such commodity futures is cotton and its derivatives that should draw the regulator’s attention. The traders and the Indian Cotton Federation are seeking suspension of futures trading as speculative activity seems to be responsible for the spiralling prices.
Forward trading in cotton can be traced to the setting up of the Bombay Cotton Trade Association in 1875, and the humble fibre has for long been traded on the derivatives platform. So, the suspension of cotton futures trading may not yield the desired outcome for the market participants.
There’s a need to understand the fundamentals and the working of the market. Unravelling myths and realities through a data-driven approach is necessary for informed policymaking.
Myths and realities
The first myth is that exchange-traded derivatives are driven by the speculative intent. The reality is that the exchange-traded cotton futures contract is a binding delivery contract, and the convergence between the spot and futures prices is observed at times.
The exchanges have reported active participation of hedgers, namely producers (Farmer Producer Organisations), ginners, millers, and exporters.
For example, open interest (OI), which measures the depth of the cotton futures market, witnessed a 37 per cent increase in 2021–22 (April 21, 2021 to January 6, 2022) over 2020–21. Consumers, producers, and processors account for 93-94 per cent of OI — with buy and sell-side at 41 per cent and 52-53 per cent, respectively.
The average trading volume is 1,769 lots and ₹120 crore, and the average open interest reported is 6,056 lots between April and December 2021.
From the delivery point of view, an average of 8,600 lots ( one lot is equal to 25 bales) have been delivered on the exchange platform with an average dispersion of over 5,000 lots between 2016–17 and 2021–22 (till December 2021). Comparing a three-month delivery (October, November, December) from 2019–20 and 2021–22, it is observed that the exchange has recorded a 256 per cent and 93 per cent increase in delivery from October to December of 2020 and 2021.
The second myth is that there is no correlation between domestic and international prices. Analysis shows a 0.97 coefficient of correlation between changes in cotton futures prices traded on the MCX and the Intercontinental Exchange (ICE). The co-movement of cotton average futures prices between the two exchanges has been observed from December 2017 to December 2021.
The third myth is that futures trading has led to price rises. Cotton is a global commodity, and its futures and options contracts have been traded on the US-based ICE, , and China’s Zhengzhou Commodity Exchange (ZCE). India is a leading producer and exporter of cotton. Despite this, India has an insignificant share in the global cotton futures market and has remained a price taker (see Table 1).
Furthermore, the stock-to-use ratio calculated from the total supply and demand of cotton shows that the proportion has declined from 36 per cent in 2020–21 to 32 per cent in 2021–22 (till December 2021), indicating that the spot price can be increased due to reduced inventory in the market.
The fourth myth is that margin is lower in the domestic futures market. Margins levied in the domestic exchanges are higher than in their global counterparts. The margin applicable in the MCX is 11.5 per cent — that is to be increased by 3 per cent from January 12, 2022 — while it is 6 per cent and 10 per cent at the ICE and ZCE, respectively.
The fifth myth is the futures contract serves very few. It is learned that the contracts are reviewed before the launch in every season, and the Product Advisory Committee comprising experts and representatives of the value chains discuss contract-related issues at least twice or more every year.
Since November 2021, the cotton futures contract in the MCX was modified to introduce RD value for a colour grade, and such modification has received positive feedback from the market participants as understood through the delivery magnitude.
So, by dispelling myths with incisive analysis, systematic anticipation of the right policy mix for the smooth functioning of the commodity derivatives and cotton futures markets is needed.
The writer is Chairman, CFAM of IIM Lucknow. The computational assistance of the MCX Research Division is acknowledged. Views are personal
January 20, 2022